High Spirits, Low Ratings

S&P says global wine and liquor outfits' strong fundamentals and solid cash flow entice them to boost debt leverage

From Standard & Poor's RatingsDirect

It's not often you see an industry where the leading player is only rated A- and the close number two is rated BB. Yet that's exactly the case in the global spirits industry, with market leader Diageo (DEO; A-) and No.2 Pernod Ricard (BB). Both have ratings that are lower than might be expected for leading players in an industry with such strong fundamentals and solid cash flow generation.

Among other industry members followed by S&P Ratings, Brown-Forman (BF.B) is rated A, Constellation Brands (STZ) is rated BB, Fortune Brands is rated BBB, and Remy Cointreau carries a BB- rating.

Standard & Poor's Ratings Services believes the stability and cash flow generation of the industry, and a strong rationale for consolidation, entices some industry players to significantly increase leverage on an opportunistic basis. The future creditworthiness of the world's largest spirits companies, therefore, will depend on the financial policies underpinning their acquisition strategies.


  The favorable trends that support the strong business profile of the global branded spirits industry look set to persist in the medium term. Demand will remain stable in volume terms -- despite per capita declines in mature markets -- thanks to a growing consumer population, and to changing taste preferences. Furthermore, the per capita reduction in consumption is shifting demand toward higher quality, strongly branded spirits, creating opportunities for price increases and improvements in sales mix.

The branded sprits industry is among the most cash generative in the consumer-goods sector. High margins can be achieved from strongly branded products, and the sector's typically limited capital expenditure requirements allow for strong free cash flow generation. Furthermore, established market positions are largely resilient.

Nevertheless, competition is fierce in a still-crowded industry. The largest participants, able to achieve critical mass in their markets, benefit most from the sector's favorable characteristics. Those that are unable to achieve this critical mass risk eroding their profitability through increased distribution and advertising costs. To ensure stable financial performance, leading spirits companies must hold a diversified product portfolio, with a suitable mix of established and growing brands across a wide range of spirit categories. As a result, the global spirits industry continues to consolidate.


  In most mature markets, rising health concerns have prompted a gradual reduction in per capita consumption. This decline is offset, however, by a growing consumer population. Although overall population figures are stagnating, the number of consumers above legal drinking age is still growing due to an aging population in most developed markets.

Overall, worldwide spirits consumption is strongly supported by a rising consumer population in the U.S., which accounts for about 40% of western-style spirits consumption by value. The U.S. market benefits from growing customer numbers, arising from its net immigration gain, and from an increasing non-migrant population of drinking age.

Global consumption is also supported by ongoing developments in consumer tastes and behaviors. For example, the importance of Hispanic and African-American consumers in the U.S. is increasing. These two ethnic groups drink less beer but more spirits and wine than the U.S. average. In addition, higher consumption among females is characterizing mature markets.


  Large, well-established spirits brands continued to grow faster than the industry average in 2005, most being aligned with the uptrading trend of the sector. According to drinks trade magazine IMPACT, the top four global premium spirit brands -- Smirnoff, Bacardi, Absolut, and Jack Daniel's -- accounted for 38% of volume growth for the top 100 premium spirit brands last year, although they represented only 8.4%% of total volume.

Operating margins in the industry are expected to increase gradually from the already high levels owing to the stable demand and favorable mix improvements, which more than offset an unfavorable geographical mix. Leading suppliers of strongly branded spirits spend about 19% of net sales on marketing and advertising, which is slightly higher than the equivalent spent in other brand-driven consumer goods industries such as confectionery (17%) or personal care (15%).

Nevertheless, these players reach operating profit margins of about 20% to 25% of net sales, compared with the operating margins of about 20% typically enjoyed by their leading peers in confectionery and personal care. Capital expenditure requirements, meanwhile, are low -- typically about 4% of sales, and, as a stable industry, little new capacity is required.


  Standard & Poor's expects the consolidation that has characterized the spirits industry in recent years to accelerate as global scale becomes more important. Even the larger players require additional scale, as none of them owns a full portfolio of leading brands in all major categories. Diageo, the industry leader, for example, doesn't own a premium tequila brand, although it distributes the Jose Cuervo products (on behalf of Tequila Cuervo La Rojena).

Lenders appear comfortable with industry prospects and cash generation, allowing companies to gear up significantly for material acquisitions. Pernod Ricard, for example, was able to tap both the equity and bank markets to fund its 2005 acquisition of Allied Domecq -- financing 26% of the acquisition through the issuance of new shares and the early conversion of an existing convertible security, and the rest through bank debt. This resulted, after some asset disposals, in a highly leveraged financial profile, with net debt to EBITDA likely to remain above 5x in June, 2006, one year after the acquisition.

Acquisition targets with high brand equity, particularly in the premium-spirit space, are likely to attract significant market premiums -- as evidenced by Bacardi's acquisition of premium vodka Grey Goose -- that could saddle the acquiring company (particularly the smaller acquirer) with a significant debt burden and higher interest expense. There's a risk that aggressive players will overextend themselves and wind up carrying burdensome debt that could significantly impede financial flexibility. As these players increase leverage, they will also be under pressure to quickly and successfully integrate acquired brands.

We will continue to assess the implementations of prospective acquisitions, in terms of expected improvement in sales mix and profitability, scale, and brand potential, but also in terms of potential integration issues. The stability and strength of the industry's cash flow generation allows us to take a slightly longer-term approach compared with that applied to other branded consumer good sectors.

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